The Myth of an Inefficient Market

But wait, Nelson. You’re a value investor. Hell, you even have a whole blog dedicated to value investing. The whole point of value investing is exploiting an inefficient market. How can you say with a straight face that the the whole notion of market inefficiency is just a myth? Have you pulled an Andrew Hallam and decided to go to the world of indexing once and for all? Oh please, just tell us and stop with this introduction that’s going on way too long!!!!

Geez, relax straw man. Have you tried booze? I don’t normally recommend it, but still. You should try it.

If you spend as much time as I do reading Seeking Alpha, Motley Fool (WHOO! REPRESENT!), Value Investors Club, Gurufocus, and the 31 other investing blogs I check from time to time, you’ll notice a few patterns, especially from the folks who exclusively dabble in the world of large-cap stocks.

Value investors, dividend growth investors, and momentum investors seem to universally love the same stocks. Fiat is more recommended in the value investor community than a mediocre chain restaurant is to tourists. We’ve already talked about how dividend growth investors LURVE the same 40 stocks. We get it guys, you like Coca-Cola. And for whatever reason, growth investors are actually quite okay paying 303030303030303 times earnings for Amazon.com, because by the year 2022 you’ll actually be able to log on and buy yourself love.

When it comes to market inefficiency, there’s the big problem. The vast majority of investors spend most of their working on the 500 biggest stocks in the market. If you combine that with all the pension funds, hedge funds, and mutual funds that are limited to the largest stocks out there because of their size, you have a universe of stocks that’s very well covered.

There’s so much competition in the world of large-caps that you have to be a special kind of delusional to think you have an edge. Hedge funds have all the money in the world to spend on research. The big mutual funds have dozens of research analysts who have already forgotten more about finance than the average investor knows.

Not only are you competing with all of those guys, but you’re also competing with all your peers. Add all that up, and there are probably millions of man hours dedicated each year to trying to figure out whether Johnson & Johnson will outperform McDonald’s. And you really think you’re going to get ahead in this world?

This is why it cracks me up whenever I hear investors who live exclusively in the world of the S&P 500 (or the ~150 largest companies in Canada) talk about market inefficiency. They’ll talk about Exxon Mobil like they have an opinion on it that matters, and it’s so, so, cute.

This is one of the reasons why I hate dividend investing so much, specifically the dividend aristocrats. Not only is it survivorship bias at its finest (spoiler alert: when you drop all the crap from an index, you tend to outperform it), but it’s essentially a bunch of work for no additional result. Since the dividend aristocrats consist of many of the U.S. market’s largest stocks, it’s essentially an index matching exercise with perhaps the benefit of a little lower downside when the market blows up.

No, if you really want to go somewhere where there’s an inefficient market, you have to venture into the world of small-caps.

Go small young man

Let me bold and italicize this next sentence, because it’s really important. If you’re going to pick stocks and you’re not investing in primarily smaller companies, your chance of beating the market over the long-term is practically nil.

But here’s another TRUTH BOMB for you. Even in the world of small-cap stocks, most are efficiently priced too.

There aren’t as many people cruising the world of small-caps, which makes it more likely that they’re inefficiently priced. But there are still thousands of investors that have scoured the balance sheet of Reitmans or Yellow Media. Your chances of finding an undervalued gem still aren’t terribly high.

Then why value invest at all? Firstly, just because a stock is efficiently priced doesn’t mean it won’t go up. The economy tends to grow, and a management team who consistently tries to improve their business will most likely catch onto something. And secondly, most small-cap stocks are priced efficiently for the short-term, while the market discounts long-term trends.

Besides, buying cheap assets tends to turn out well, provided they aren’t encumbered by too much debt. The potential for upside tends to be bigger when you’re buying stuff that’s already on sale.

There’s a reason why I continue to say most people reading this blog should stick to indexing. It’s hard to find stocks that are inefficiently priced even if you know what to look for. By adding in the handicap of avoiding the small-cap universe, it’s virtually impossible to beat the market. And if you’re not beating the market, why try?

7 Comments

An Excerpt : Note the exceptional rate of return this particular dividend investor has ***

The ETF you mention (XIU.TO) does have a very low MER, by Canadian standards, but it’s performance has been less than stellar because of the high mining and energy content in the TSX index. For the Jun 30, 2008 to Jun 30, 2015 period I computed these total return results:
XIU.TO = 19.60% (all equities – 100% Cdn)
SPY = 86.45% (all equities – 100% U.S.)

This fellow has posted all over the internet that indexers are basically a cult of losers…You can’t even come to a happy medium. Some select individuals think they have a magic formula vs. maybe just being partially fortunate for certain periods of time being favorable for their picks.

Good post. What I struggle with in the investment game is that everyone seems to think it is an all or nothing game. I am a dividend investor so that is all I should hold. I am an indexer so I can only hold index funds.

Why not manage a blend – have indexes as the core part of your portfolio and then supplement with dividend stocks, mechanical investing strategies (which I use) small-caps, or other. There needs to be a specific plan to that – not just pick strategies out of a hat – and reasons for what you are choosing. I believe the most important part is the plan (asset allocation, risk tolerance, etc) and then sticking with that plan.

Actually, the most important part is tracking your portfolio to make sure that if you do add in other asset classes/investments you can compare against the market. If you are beating it awesome, if not you suck and need to change strategies.

I just enjoy picking stocks and keep 90% of my investments in stocks. I know some think it is foolish but hey …..
Overtime I have developed a contrarian / value investing style. I have kept good records and I have been investing since 1999 and was an enthusiastic (but late and ill fated) participant in the internet bubble and well bought a lot of falling knives in 2008 (AIG, banks etc). In spite of everything and the steep learning curve, I have an annualized return of close to 10%.I have a portfolio of mid 7 figures. Earlier this year I was downsized from my job into early retirement (mid 50’s). However I am not overly worried as I have developed a skill set/hobby which keeps me engaged and has made me financially independent. There are worse hobbies to have.

Great post ! I learned during he CFA that markets get more and more efficient with information, if there is no public information, then its technical analysis and price action only, to get to highly efficient markets, we would need insider info, and that will never happen, so markets will always remain unefficent.